In the field of financial investment, diversification is a technique that attempts to reduce risk by constructing a broad portfolio and allocating investments among various financial instruments, industries and other categories. The technique aims to mitigate risk by investing in different areas that would each react differently to the same event.
There are many different factors that affect investment returns. The classical Capital Asset Pricing Model (CAPM) attempts to explain returns in terms of two main drivers: systematic risk and idiosyncratic risk. Idiosyncratic risk is specific to an asset or small group of assets and has little or no correlation to market risk. It can therefore be substantially mitigated or eliminated from a portfolio by using adequate diversification. Systematic risk, under the CAPM, is the risk that arises from exposure to the market. This systematic risk is captured by market beta, which is the sensitivity of a security's return to the overall market. Because systematic risk cannot be decreased by diversification, investors are compensated with expected returns proportional to the extent in which they bear this risk. Thus, the expected return can be viewed as a function of its beta to the market.
Arbitrage Pricing Theory (APT), on the other hand, holds that the expected return of a financial asset may be modeled as a function of various macroeconomic factors or theoretical market indexes. Generally speaking, a factor can be thought of as an attribute or characteristic relating a group of securities that is important in explaining their returns and risk. Today, factors are generally categorized into three main groups: macroeconomic, statistical, and fundamental. Macroeconomic factors may include measures such as inflation, GDP, and other macroeconomic measures. Statistical factors use econometric models to estimate the risk and expected performance of assets. Fundamental factors relate to characteristics of an asset such as membership in a particular industry or global region, valuation ratios, and technical indicators.
There are many possible factors that can be used to explain investment returns and risk. However, not all factors are created equally. Empirical studies of certain particular factors have identified these factors as having exhibited excess returns above the market. Such factors may be called risk premia factors or simply risk premia.
Factor investing is an investment strategy in which assets are selected based on risk premia, or attributes that are associated with higher returns. Factor investing can thus be thought of as selecting return-generating attributes rather than selecting asset classes or individual assets such as stocks. Risk premia factor portfolios can be thus be created by selecting assets which exhibit the risk premia. Such factor portfolios can be combined in various proportions to capture the desired exposure to those risk premia.
Portfolio construction entails both selection of assets and weighting of those assets. Traditional approaches to portfolio construction in the equity universe commonly involves either low-cost capitalization-weighted index funds (i.e. passive management) or active management. One criticism of passive management is that because exposure to an individual stock is automatically increased when its price appreciates and is automatically decreased when its price falls, cap-weighted index funds over-weight stocks that have already “run up” in value and under-weight stocks that have performed relatively poorly. It can be argued whether or not this is a good effect depending on overall equity market conditions at given times, but one clear fact is that optimizing the weighting of stocks is not an explicit or even indirect objective of a cap-weighted index. At the other extreme, active management tends to be opaque, entails high management and turnover expenses, and has been shown in the aggregate to more often than not underperform market indices (net of fees) over long time horizons. So-called “smart beta” investing offers a third option for portfolio construction. The term “smart beta” may be applied to a broad array of investing strategies whose common feature is that they that use non-cap-weighted indices. Smart beta strategies may offer many of the same benefits as traditional passive investing, including broad market exposure, diversification, liquidity, transparency, and low-cost access to markets. Also, they may offer the same types of performance profile of well-performing active managers, with all the benefits heretofore described of passive management.